In the early days of the pandemic, deal making in the middle-market came to a sudden and startling halt. Since then, overall M&A activity has reached a frenzied pace across virtually all industries and market segments and shows virtually no signs of slowing down. In this month’s episode, Chris and Chase talk through the dynamics driving the surge in transactions, and how both buyers and sellers are navigating the lingering impacts of the pandemic.
Transcript
Chase:
Hello, and welcome back to What’s Next hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I’m Chase Hoover, and I’m here with my co-host, Chris Kramer today to talk about what the M&A environment looks like in the late stages of the pandemic. Good morning, Chris.
Chris:
Good morning, Chase. How are you doing today?
Chase:
Doing very well.
Chris:
Good. Well, so you might recall that when the COVID pandemic first reared its ugly head back in March of 2020, at least in our world, and I think just across the world more generally, M&A activity really ground to a pretty much screeching halt. People were trying to figure out what the pandemic was going to mean. They were trying to figure out whether they were even going to have a business post-COVID, whenever that might have been. And then long about the summertime, when things began to be a little bit more clear, companies that realized they weren’t maybe as negatively impacted, and buyers that were already in the talks with those companies, kind of said, “Hey look, we can see some light at the end of the tunnel, so we’d like to reengage in the process.”
That created more demand and of course, some challenges around deal terms and getting clarity around the future outlook, but at least the activity level kind of improved. Fast forward to today, and we’re seeing a huge amount of activity. We’re seeing companies ready to sell for various reasons that we’ll get to here. We’re seeing buyers approaching companies like they frankly never have in the past. And so now we’re seeing different impacts from COVID and trying to figure out how can we get deals done in light of supply chain issues, in light of high-interest rates, and in light of the workforce challenges and getting people actually to come to work.
Chase:
Right. So initially once everybody realized that the world hadn’t “ended” at the start of the pandemic, the question in dealmaker’s minds and particularly on the buy side was, “Is the business going to recover?” Because the last few months, maybe, haven’t been so good or there’s a lot of noise in the numbers. Again, fast forward to now, a lot of businesses have stabilized or never really were all that jolted to begin with. But the second order consequences of the pandemic and other things that have developed in the intervening 12 or 18 months, such as general inflation in the economy, shortages in the availability of labor and physical goods stemming from supply chain, are really the hot buttons now. What does the future look like now that the truly acute COVID consequences have come and gone, but some of their effects are likely to stay? So I think the first thing we want to talk about is how buyers are trying to get comfortable, getting a picture of the new normal, the post-COVID sorts of levels.
Chris:
Yeah. It’s kind of interesting. Previous to the acute impacts that Chase alluded to in, let’s say the middle of 2020, we have different issues. Now we have issues around can we meet our forecast? Are we going to be able to fulfill our orders? Can we get raw materials to be able to actually make the products? Can we find workers to actually deliver the services? And so the conversation has sort of shifted to not, “Hey, can you recover? Was COVID a one-time blip? In fact, were you sort of down, if you were, mainly due to COVID?” That conversation’s now shifted to kind of almost irrespective of your recent performance, what does the future look like in light of all these challenges?
And I’m hearing a lot of stories about certain companies, a roofing contractor that we know, for example, where all their supply for the entirety of 2022 is going to be on allocation. So they’re going to be limited in what they can do just by virtue of raw materials. And I don’t think that’s a unique situation. I think this whole supply chain challenge that many businesses are facing, and frankly, consumers are seeing in terms of delays in getting shipments of consumer goods, etc., that’s here to stay I think, deep into perhaps even 2023.
Chase:
Right. And back around the third and fourth quarter of 2020, everybody was talking about the whole notion of a V-shaped recovery and this pent-up demand. And that was sort of held out as the positive or the silver lining here. Well, pent-up demand is great. But what about held up supply? Because if you’ve got this sudden resurgence and everybody’s got money in their pocket and they’ve got more sort of bullish sentiment and they’re spending money out in the markets, naturally, it was pretty low hanging fruit to see that we were going to have this supply chain crisis. How are you seeing or what are you seeing rather, in terms of buyers creatively? Said differently, what are they doing in diligence to try and assess what that new picture looks like?
Chris:
Well, one of the things before we get to the diligence, just in terms of deal structure, is kind of a sharper focus on something that has been around for a long time, something known as an earnout, which is basically contingent consideration. And that contingent consideration is a function of future performance and trying to agree on some level of a minimum performance and then some way to measure what the additional consideration would be if you hit those numbers. And one example, just a few weeks ago we had a client that was willing to accept an earnout with certain milestones. And literally, within 30 days has come to the conclusion that he may not hit the numbers. And if he’s not going to hit the numbers, then the overall economics of the transaction don’t work for him.
So in that case, he’s actually going to delay moving forward with a transaction because he believes that he needs more clarity and that clarity may not happen for a year or more. So that’s one aspect. As far as due diligence, I think it is getting to the root of supply chain issues, a deeper focus on where, let’s say in this case, raw materials are coming, from multiple sources of supply, whether it’s sourced internationally or domestically. And by the way, pricing on some of these raw materials is a big consideration also. So deeper scrutiny on margins, what’s known as a quality of earnings assessment where a buyer hires an accounting firm to dig into the numbers in great detail to try to understand what the real margins are and what some of these supply shocks might lead to. Those are a couple of things we’re seeing that are happening right now.
Chase:
Yeah. I’m glad you mentioned earnouts because I’ve actually seen, and I know others are seeing, an interesting and maybe somewhat unique and new way in which earnouts, contingent consideration, are factoring into these deals. While earnouts are nothing new, they’ve sort of increased in popularity over the last couple decades or so. But they’ve typically served to, what we might call bridge the valuation gap, where you’ve got a seller or a group of sellers that think the business is worth X and it turns out the buyers or the market more broadly think it’s worth X minus something, right? So the there’s a difference in the expectation of value.
Nowadays, we’re still seeing that, but we’re also seeing almost the complete opposite, which is, “My business really benefited from COVID. I was in a position to capitalize on something like working from home or PPE.” Or if COVID and the post-COVID economy were of significant benefit to you, now buyers are wondering, “Is it sustainable?” And so, whereas before, it was sort of “prove to me that you are going to hit these numbers,” now earnouts are serving the function of “prove to me that you can sustain these numbers.” And that’s a really interesting thing for business owners to consider because you might be thinking, “Hey, I’m killing it right now so I should warrant a very high value.” But there may be some trepidation on the part of the buyer saying, “Yeah, you’re doing really well, but is this going to hold up over time? “
Chris:
Yeah. And if you think about a transaction, it’s really an assessment of risk on both sides of the equation and from both party standpoints. So the buyer doesn’t want to assume any more risk than they have to, and the seller’s trying to off the risk, because if the seller’s accepting risk, he may as well not sell the company, to some extent. So what I’ve seen in a recent transaction is a buyer putting forth an earnout target that basically is at, or slightly above, the current performance. So Chase to your point that the sustainability is really what’s in question, but for the continuation of the supply chain or a resurgence of COVID or some other more broad economic issue, it’s really a, “Hey look, if you can do the numbers that you’re doing, we’ll pay you the money, but we’re afraid of a decline or a further decline.”
So years ago and in many cases, to your point, earnout was structured to allow for, “Hey, we’re going to grow really fast. Our forecast is really robust. We think the future outlook’s super bright and we want to be paid for that.” The buyer would say, “Oh, wait a minute. If you hit the numbers, we’ll pay you.” Now it’s sort of shifted to, “As long as you don’t decline further, we’ll pay you, but by the way, we’re going to carve out some of the sort of base purchase price and make it contingent.” So that’s a pretty fundamental change at least in the mindset between buyers and sellers, I would say.
Chase:
Yeah, absolutely. Let’s say I’m a seller and pretty much every buyer or a potential buyer that I’m talking to wants to introduce this contingent component. And I’m, to your point, trying to offload risk. I’m trying to maximize the value of what I’ve built in the sale, and I want to push as much of that value away from risk and into whatever it is, cash at closing or stock consideration at closing. What are some of the things that I can do from a positioning standpoint or a marketing standpoint to a buyer to try and get them comfortable with, let’s say a lower earnout threshold or a lower earnout amount. How can I sort of paint the future in the most favorable light possible?
Chris:
Yeah, I guess one way that I would answer that would be to think of the business value or the value drivers or the premium, if you will, in the form of intangible value. So, businesses have some base amount of assets, whether they’re financial assets, accounts receivable, etc., perhaps inventory, perhaps fixed assets. And then they have a value that they want to sell the business for. And the gap, if you will, or the difference, is intangible. So there are things like customer lists, supplier relationships, brand names, perhaps patents or trademarks, something that’s legally protected, etc. And I think the more you can demonstrate to a buyer that those intangibles are endemic to the business itself versus let’s say a key person or a leadership team, etc., you can hopefully convince them that what they’re buying has legs … longevity … and has the ability to withstand some of these more short-term, or hopefully short-term, situations.
That would be one thing that I would say. And number two, I think as a business owner, if you can demonstrate or show what the history has been perhaps when you’ve had other downturns, when you’ve had a loss of a customer, when you’ve had a spike in let’s say an input cost or something like that, to be a little more proactive and play a little bit of offense. Because what happens in a transaction when you agree on a price and you go into an exclusive period known as due diligence, the buyer is going to move heaven and earth to pick apart every aspect of your business, including all of your numbers.
So the more you can be prepared for that, and the more you can play what I call offense and show them or preempt, or even disclose something upfront, such as “Hey, look, we had this issue in 2019, and here’s what caused it. We know our business so well, that we could almost explain or almost even predict what caused that or what might cause something in the future.” That gives a buyer a lot more comfort than, “Hey, in the future, we can model out some scenarios. We can sort of have confidence that you could respond to again, a supply shock or a change in input costs or loss of a customer or whatever it is.”
Chase:
I think that’s right. I think painting a narrative if you will, and not in a manufactured or “false” sense, but really bridging the gap to, “Hey, here’s what we’ve done historically. Here’s how we recover from this, or we sustain this, and here are the underlying catalysts that we expect to factor in.” So sort of painting the picture, “Hey, we survived this downturn and two or three of our major competitors didn’t or one or two of them already sold. So we’ve got more market share to go after. We think there’s growth to be had.”
There are things like that where you’re not just saying, “Hey, we’re likely to recover. Trust us, we’ve done it before.” You’re actually pointing to tangible aspects or opportunities for you to take advantage of. I think that’s really key.
So getting beyond earnouts or contingent considerations, one of the other things that a lot of folks are asking us about, and there’s a fair bit of questioning going on is, what about deal terms? What about protections? What about the legal sort of risk sharing that is glutted within any purchase transaction? Things like representations and warranties, what’s developing there? What are the trends?
Chris:
Yeah. So as a seller, again, along the lines of this sort of risk allocation or risk sharing, a buyer is going to ask you, as the owner of the business and the seller, to represent to certain things, meaning you’re making promises that certain things either are not present, or you’re not aware of them. So we don’t know of a loss of a major customer. We don’t know of any lawsuits. We don’t know of a number of things. Those are called representations. And then there’s an aspect of the transaction in the back of the purchase agreement called the warranty, which is another way to say the remedy. So if you breach a representation, then you are liable for some aspect of damages, right? Now, the buyer has to show, first of all, that there were damages. And second of all, that they were caused by one of your breaches.
And in order to protect the buyer against those breaches, they generally have what’s known as a holdback or an escrow holdback. And that’s an amount of the purchase price that’s set aside for a period of time, 12, 18, 24 months typically, whereby they have something to go back after, right? If they’re paying you a lot of cash at closing, and there’s no escrow, then if there’s a breach, they don’t have anything to go after. What we’re seeing more and more is the use of representations and warranty insurance, which is effectively again, shifting risk away from the buyer and the seller, to an insurance carrier. And the tradeoff is a premium, which is actually fairly expensive, but not usually relative to the entirety of the transaction value. You might see a $200,000, $300,00, $400,000 premium on a $20 million, $30 million, $40 million, $50 million transaction … rough numbers. But what it really does is let you lower the amount of the percentage of the escrow.
Typically, we might see an escrow hold back the amount of 5% , 7%, 10%, sometimes even greater, of the purchase price. So on a $50 million transaction, you might have a $5 million holdback. What a rep and warranty insurance policy will do is lower that to something closer, to say 1%, which would only be $500,000. A lot of times that’ll be split between the buyer and seller and you can materially increase the amount that you can get at closing as a seller and mitigate the risk that you have to actually suffer some detriment to the escrow if it were in place.
What typically happens is there are carve-outs to the policy, and those can be many and varied, but generally, they’re going to be for known liabilities or the things that are uncovered in the due diligence process. Every situation’s different, but we’re seeing more and more usage of representations and warranty insurance to actually increase the cash at closing that you can command as a seller.
Chase:
I’m glad you called out the whole notion of excluded carve-outs here. Because if the notion or the concept of rep and warranty insurance sounds like a bargain or a little bit too good to be true, that is a clear caveat that if the carrier or their broker uncovers in diligence, or if the buyer uncovers and then shares with that carrier, a specific looming issue that could potentially give rise to liability, insurers are not in the business of knowingly paying out claims. So they’re going to carve that out. And so a rep and warranty policy are really only as good as what it covers, right? It’s not the “silver bullet.” We’ve seen in several transactions, the use of a rep and warranty policy to mitigate the dollar amount of an escrow, generally, but several ancillary escrows of a smaller dollar amount, but pertaining specifically to identified issues around, let’s say, state tax liability or something specific to a very identifiable issue.
I think the last thing we really want to cover here as we come to a close is what are you seeing just in terms of overall demographics and what’s driving folks to sell in this post-COVID environment. Because I think in the immediate wake or aftermath of the acute portion of the pandemic, a lot of business owners were saying, “Gosh, I don’t know if now’s the right time to sell, that the performance is off. We need to get recovered here.” But now that things have sort of leveled off and settled a bit, what are the demographics looking like in terms of folks who are looking to sell and why are they looking to exit?
Chris:
Yeah, I don’t think it’s really any different than it has been for the last, I don’t know, 5 or 10 years anyway, maybe longer and some people call it the silver tsunami. Some people call it the aging baby boomer population, but it’s business owners getting older and realizing they don’t have an unlimited amount of time left. Meanwhile, I think what’s happened primarily because technology has facilitated this and a few other factors, people are kind of working longer and able to run a business without having to, so to speak, be there every day. And those people are now in their, let’s say, mid to late 60s, maybe even 70s, whereas maybe 20 plus years ago, they would’ve already considered selling. So there are still a fair amount of business owners that I think are looking to exit.
Meanwhile, on the buyer side, same demographic, low-interest rates, a lot of capital to deploy, and frankly, fewer and fewer good companies available because let’s face it, a private equity moves pretty quickly and building a great company takes decades in most cases. And so there are sort of fewer and fewer opportunities out there which really is serving in part, to drive up the price a little bit, right? You’re seeing in many cases record multiples, so kind of the best time ever to sell the business.
And then you also have the phenomenon of a lot of buyers going direct to a business owner. We hear this all the time, “We’ve been approached (either it’s a competitor or it’s a private equity fund). They want to talk to us. They want to make us an offer. We weren’t really thinking about it. What should we do?” And of course, if you can get in a preemptive discussion with a seller as a buyer you like, that’s a whole lot better than, let’s say, fostering an auction. But the point is that there’s just more and more private equity money out there, public companies, which we might call strategic buyers, are realizing they can’t really grow that well organically. So growing through acquisition remains a very viable option. And so, as more and more business owners are getting older, you’re going to see a continuation of the activity level.
Chase:
Yeah, totally agree. And I think when you pair all that, that’s sort of consistent with the trends we’ve seen both pre- and post-COVID with two other things. The first of which is A, what I might call sort of COVID PTSD where, “Hey, we just successfully navigated these really choppy waters. I may not have been looking to sell originally for another 3, 4, 5 years into my retirement. But knowing that, that could happen again potentially, now might be the right time to sell, especially given where valuations and overall market pricing is at.” And then the second thing I would highlight is just the kind of “political risk” here.
There’s some tax legislation in the works, it’s still very fluid, potentially impactful changes to things like the step up in basis, estate tax treatments, and potentially capital gains rates. I think that’s all pushing folks to really explore the conversation maybe more deliberately and intentionally than they did before. I think we could talk about this for another couple of hours, but in the interest of preserving our listeners’ time, I think we’ll wrap it up. Thanks very much, Chris.
Chris:
Thank you, Chase.
Chase:
And thanks as always to you all for listening. Quick, fine print, this podcast is for general informational purposes only. It does not create an advisor client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for a specific situation. As always, we’d like to thank our wonderful sponsor, Acuity Advisors. Tune in next time everyone, take care.